Case Overview, Over-the-Counter Derivatives

This document provides background information and summarizes the debate over governement regulation of over-the-counter derivatives. The links to the left will lead you to public documents that we have found.

          Derivatives are complex financial instruments that are widely used in a broad variety of business markets. They are a way a trader of some commodity can reduce the inherent risks involved in any market where prices can swing quickly and broadly because of changing business conditions. For example, suppose a company in the United States purchases goods from a Japanese manufacturer and that manufacturer needs three months to prepare the product and then ship the goods to the United States. Say the contract specifies that the manufacturer won't be paid until the goods arrive in the United States and that the United States importer will pay the bill in yen (the Japanese currency). But what happens if in that intervening three months the yen rises in value against the dollar? Such a change in currency valuations means that it will now take more dollars to purchase the amount of yen owed to the Japanese manufacturer. This alteration in the yen-dollar relationship could conceivably wipe out much of the profit anticipated by the American company. The way the American company can protect itself is to buy a currency derivative that will compensate it at predetermined rate if the yen-dollar valuation changes significantly and adversely over a fixed period.
          Derivatives have emerged in a broad array of business markets, including interest rates, grains and other agricultural products, precious metals like gold, and different forms energy such as oil, gas, and electricity. Many companies specialize in trading of these financial instruments, some of them quite esoteric, and the large financial houses like Goldman Sachs and J.P. Morgan have departments that engage in derivative trading. All of these derivative instruments are characterized by a high level of mathematical complexity; computers not only do the number crunching but are sometimes programmed to issue buy and sell instructions to brokers at lightening speeds to take advantage of small movements in price. The result is that not only is it difficult for people outside the brokerage industry to understand how derivatives work, but it also makes it difficult for government to regulate them.
          In the wake of the collapse of Enron, an energy company that built up a substantial business trading energy derivatives, evidence emerged indicating that it used it electronic energy trading network to manipulate the market for electricity. (Due to deregulation, electricity contracts can be bought and sold by producers, middleman, and distributors.) Evidence also indicated that the state of California overpaid for electricity because market manipulations created an artificial shortage, driving up the price for electricity not under long-term contract to distributors. California Senator Dianne Feinstein introduced legislation in the 107th Congress designed to bring unregulated derivatives under the jurisdiction of federal agencies.
          The Feinstein bill generated a furious lobbying campaign by the companies and industries that would be brought under regulation. Organizations like the International Swaps and Derivatives Association and the Bond Market Association initiated a campaign to convince legislators that their particular market did not need government regulation. Said one lobbyist "we made the argument . . . that there is no need to regulate these particular instruments by any entities, because in fact what you would do is have regulations imposed on them that would then prove adverse to their efficient operation and they wouldn't be used." They end result, he added, is that traders in an affected market would rely "on some other financial instrument that may not be as efficient." In the end the Feinstein bill never made it out of committee.